Traditional vs. Roth IRA: An Introduction and Comparison

The Individual Retirement Account (IRA) allows anyone who earns income the opportunity to save for retirement, regardless of the plans offered by his or her employer. An IRA is not an investment in itself, it’s an account type. Within the IRA, you can keep your money for the future in money market funds, CDs, stocks, even gold. The government limits how much you’re allowed to invest in an IRA each year. Here are the contribution limits for 2009. In addition, the government also reduces these contribution limits for certain types of IRAs depending on your income. For individuals over the age of 50, the government raises the contribution limit to help “catch-up.”

Traditional and Roth IRAs

There are two main “flavors” of IRAs: traditional and Roth. Both types include the benefit of allowing money to grow tax-free while invested and untouched. That means that even while your account grows, you won’t have to pay taxes on capital gains or interest. That leaves more money in the account, with returns possibly compounding upon returns. A traditional IRA adds the benefit of tax-deductible contributions. In other words, if you contribute $5,000 to your traditional IRA, if you aren’t excluded by your level of income, you can deduct the $5,000 from the income you report on your tax return. You will pay tax, however, when you are retired and take a distribution from the account.

Contributions to a Roth IRA are not tax-deductible. The most common way of describing this is that you invest in Roth IRAs with “after-tax” money and traditional IRAs with “pre-tax” or “before-tax” money. When you take a distribution from your Roth IRA after you’ve retired, you will not pay tax on your capital gains, of which the plan is to have many.

You can withdraw money from an IRA at any time, but if you do so before age 59 1/2, you may face some penalties. First, with a traditional IRA, you will be taxed on your contribution and gains withdrawn, plus be subject to a 10% penalty in the form of a tax for “early withdrawal.”

Which IRA to choose?

In general, when deciding between a Roth IRA and traditional IRA, the choices comes down to your tax bracket. If you think you have a lower tax rate now than you will when you retire, the Roth IRA will keep you from paying tax on your contributions when you withdraw after age 59 1/2. If you think you will have a lower tax rate in retirement, take the deduction in a traditional IRA now and pay the tax on contributions when you withdraw after 59 1/2. Sounds simple, right? There are a lot of variables to consider. For example, will this country’s tax rates be much higher by the time you retire?

More importantly, will the government decide to change the tax advantaged status of these accounts, and will that change affect current investors, before you reach retirement? Many people hedge their bets on the future tax rates by investing a portion of their maximum allowed contribution in a traditional IRA and the remaining portion in a Roth IRA.

There are numerous nuances to consider as well. If your income is too high to qualify for a Roth IRA right now, you can contribute to a non-deductible traditional IRA and “recharacterize” the IRA as a “Roth IRA” by paying taxes next year, regardless of your income level in 2010. There are certain circumstances in which you can withdraw your money from a Roth IRA without paying the 10% penalty. Using your Roth IRA to pay for your first house is one of the qualifying cases. Furthermore, you can re-contribute to a Roth IRA if you withdraw your contributions.

If you’re self-employed, even if only as a side job to complement your main career, you can also contribute to a SEP IRA as your own employer. This greatly increases the amount you can save for retirement.

Setting up your initial IRA

I find it important to look for low-cost investments for IRAs. Since they are tax-advantaged — you don’t pay taxes on gains and interest while your money stays with the IRA — you can freely trade without having to report your income to the government, leaving more money working for you. For the last few years, I have been using Vanguard exclusively for my IRAs. They have low cost index funds and solid money market funds available. The account opening process is straightforward, and once your initial account is active, it takes only a few clicks to contribute, transfer money from one fund to another, and create automatic investment plans.

Vanguard plays host to my Roth IRA and I have been very pleased with them so far. I’m still quite young and do not yet have a traditional IRA but I do have a 401(k). The Roth is my primary account because I expect to pay more taxes in the future than I do now.

If I ever move companies I will set up a traditional IRA with Fidelity foe to rollover. I like vanguard but I always like to diversify my accounts across institutions.

Only if your future distribution from your IRA constitutes your only income each year. If you still have a significant level of income when you begin drawing on your IRA, then the comparison between today’s marginal tax rate and the future effective tax rate breaks down.

Nevertheless, future tax rates are nearly impossible to predict, particularly if you’re looking forward 30 years or more like many people who are just starting with IRAs.

“When you take a distribution from your Roth IRA after you’ve retired, you will only pay tax on your capital gains, of which the plan is to have many.”

Actually, as long as you meet the basic requirements of the Roth (at least 59 & 1/2 years old and had the account for 5+ years), the capital gains are tax free. Otherwise, there’d be little difference between a Roth and a regular non tax-advantaged account.

“When you take a distribution from your Roth IRA after you’ve retired, you will only pay tax on your capital gains, of which the plan is to have many.”

I’m no expert, but if you’re 59 1/2 and have had the account for more than 5 years, don’t you get everything out of our Roth IRA tax free? That’s the whole point, you put after tax money in and all of your growth comes out tax free later. Have I been completely misunderstanding the differences between Traditional or Roth or is Flexo wrong?

Since IRAs are limited in the amount you can contribute, as opposed to investment funds I use for dollar-cost-averaging, I’m trying to go the cheapest route: I opened my IRA with Sharebuilder (which I use for my other investment needs already, and which works great with an ING Direct account). No minimum deposit, no annual fee (Vanguard’s $25 annual is already 0.5% of the $5,000 you can invest). Then for my IRA investment, I just deposit cash (as much as I can at the beginning of the year), and as soon as it hits $5000, use it to buy a single Vanguard stock index ETF (VTI, since I have a long ways off till retirement). It’s only a $4 fee to buy the ETF using their “automatic investment” option (unless I split it up into 2 or more purchases), and management fees are much smaller compared to mutual funds. Also, if something happens and some year I can’t make any contributions, I won’t be charged another $25 for just having my money sit there.

Downside, of course, is that Sharebuilder doesn’t have access to Vanguard’s mutual funds if you DO want to go that route, which is much cheaper for dollar-cost-averaging.

You can avoid Vanguard’s $25 annual maintenance fee by accepting electronic delivery of statements and prospectuses (prospecti?). I’ve never been charged a fee at Vanguard (that isn’t wrapped into the mutual fund price).

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